“Thus spoke Zarathustra” (or the “Eternal recurrence of the same”)

Two years ago, in the JH 2010 version Bernanke concluded:

The Federal Reserve is already supporting the economic recovery by maintaining an extraordinarily accommodative monetary policy, using multiple tools. Should further action prove necessary, policy options are available to provide additional stimulus. Any deployment of these options requires a careful comparison of benefit and cost. However, the Committee will certainly use its tools as needed to maintain price stability–avoiding excessive inflation or further disinflation–and to promote the continuation of the economic recovery.

That was the hint for QE2 and markets reacted accordingly: Long rates rose, the stock market went up ,the dollar down and inflation expectations increased.

Those movements, however, were short-lived because there was no specified goal or target to guide monetary policy.

Two years later:

When significant financial stresses first emerged, in August 2007, the FOMC responded quickly, first through liquidity actions–cutting the discount rate and extending term loans to banks–and then, in September, by lowering the target for the federal funds rate by 50 basis points. 1 As further indications of economic weakness appeared over subsequent months, the Committee reduced its target for the federal funds rate by a cumulative 325 basis points, leaving the target at 2 percent by the spring of 2008.

Yes, it did respond quickly, but just to avert a repeat of the banks “falling as dominoes” as in the early 1930s.

The Committee held rates constant over the summer as it monitored economic and financial conditions. When the crisis intensified markedly in the fall, the Committee responded by cutting the target for the federal funds rate by 100 basis points in October, with half of this easing coming as part of an unprecedented coordinated interest rate cut by six major central banks. Then, in December 2008, as evidence of a dramatic slowdown mounted, the Committee reduced its target to a range of 0 to 25 basis points, effectively its lower bound. That target range remains in place today.

As late as late July 2008, the view was that monetary policy would soon have to be tightened!  In fact, the Fed´s response to economic developments from the start of this recession revealed that policymakers were decidedly cautious. Furthemore, given the central role of expectations of future central bank policy in the monetary transmission mechanism, an easing or tightening of policy can consist of any action, or inaction, by the Central Bank that alters the public´s expectations. From that perspective it seems that monetary policy actions from late 2007 into 2008 could be classified as ‘irresponsible tightening’!

Despite the easing of monetary policy, dysfunction in credit markets continued to worsen. As you know, in the latter part of 2008 and early 2009, the Federal Reserve took extraordinary steps to provide liquidity and support credit market functioning, including the establishment of a number of emergency lending facilities and the creation or extension of currency swap agreements with 14 central banks around the world.

Just shows that the level of the policy rate is a poor indicator of the stance of monetary policy. It can be terribly tight even if the rate is zero!

 Unfortunately, although it is likely that even worse outcomes had been averted, the damage to the economy was severe. The unemployment rate in the United States rose from about 6 percent in September 2008 to nearly 9 percent by April 2009–it would peak at 10 percent in October–while inflation declined sharply. As the crisis crested, and with the federal funds rate at its effective lower bound, the FOMC turned to nontraditional policy approaches to support the recovery.

As the Committee embarked on this path, we were guided by some general principles and some insightful academic work but–with the important exception of the Japanese case–limited historical experience.

Where´s all the conviction Bernanke demonstrated in his recommendations for Japan back in late 1999? He could certainly have acted much more forcefully as Fed Chairman several years later.

In the Conclusion:

Early in my tenure as a member of the Board of Governors, I gave a speech that considered options for monetary policy when the short-term policy interest rate is close to its effective lower bound.31 I was reacting to common assertions at the time that monetary policymakers would be “out of ammunition” as the federal funds rate came closer to zero. I argued that, to the contrary, policy could still be effective near the lower bound. Now, with several years of experience with nontraditional policies both in the United States and in other advanced economies, we know more about how such policies work. It seems clear, based on this experience, that such policies can be effective, and that, in their absence, the 2007-09 recession would have been deeper and the current recovery would have been slower than has actually occurred.

As I have discussed today, it is also true that nontraditional policies are relatively more difficult to apply, at least given the present state of our knowledge. Estimates of the effects of nontraditional policies on economic activity and inflation are uncertain, and the use of nontraditional policies involves costs beyond those generally associated with more-standard policies. Consequently, the bar for the use of nontraditional policies is higher than for traditional policies. In addition, in the present context, nontraditional policies share the limitations of monetary policy more generally: Monetary policy cannot achieve by itself what a broader and more balanced set of economic policies might achieve; in particular, it cannot neutralize the fiscal and financial risks that the country faces. It certainly cannot fine-tune economic outcomes.

Unfortunately the conduct of monetary policy, by allowing spending to take a plunge, has strongly contributed to the fiscal and financial risks in place.

As we assess the benefits and costs of alternative policy approaches, though, we must not lose sight of the daunting economic challenges that confront our nation. The stagnation of the labor market in particular is a grave concern not only because of the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last for many years.

Over the past five years, the Federal Reserve has acted to support economic growth and foster job creation, and it is important to achieve further progress, particularly in the labor market. Taking due account of the uncertainties and limits of its policy tools, the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.

Back in 2010 he ‘hinted’ on QE2, this time around Bernanke has all but confirmed a new round of ‘policy accommodation’. But has he learned that for that to be really effective he has to state a goal or target?

In a critical paper presented at the conference today, Woodford (page 44) suggests just such a target:

An alternative that I believe should be equally easy to explain to the general public, but that would preserve more of the advantages of the adjusted price-level target path, would be a criterion based on a nominal GDP target path, as proposed by Romer (2011) among others. Under this proposal, the FOMC would pledge to maintain the funds rate target at its lower bound as long as nominal GDP remains below a deterministic target path, representing the path that the FOMC would have kept it on (or near) if the interest-rate lower bound had not constrained policy since late 2008. Once nominal GDP again reaches the level of this path, it will be appropriate to raise nominal interest rates, to the level necessary to maintain a steady growth rate of nominal GDP thereafter.

Good to see that the idea is gaining traction.

Update: Lars Christensen has a post on Woodford´s paper

Update 1: Lars does an encore on Woodford´s paper

Update 2: Scott Sumner takes on the “low rates=accomodative monetary policy” syndrome.

Update 3: David Beckworth on Woodford´s endorsement.

4 thoughts on ““Thus spoke Zarathustra” (or the “Eternal recurrence of the same”)

  1. Pingback: Michael Woodford endorses NGDP level targeting « The Market Monetarist

  2. Pingback: “Thus spoke Zarathustra” (or the “Eternal recurrence of the same ... | Online Study Zone

  3. If your tire is flat, it does not matter how much air you pump into it—it matters if you inflate it to the proper pressure.

    The Fed is saying “Look how much air we pumped into the economy–we are doing our job!”

    The economy is still flat.

    Likes Nunes says, unless you have a target, you are just pumping air.

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